Audit of Fed finds conflict-of-interest weakness

RonaldD. Orol

WASHINGTON (MarketWatch) — A long-awaited audit of the Federal Reserve’s emergency lending programs on Thursday urged several reforms, including an overhaul of the central bank’s conflict-of-interest policies.

The Government Accountability Office found that many employees and contractors of the New York Fed were allowed to keep investments in companies that received Fed assistance.

William Dudley, the current president of the New York Fed but at the time the head of its open-markets group, was granted a waiver to let him retain his shares in American International Group Inc.
AIG, -0.89%
and General Electric
GE, -0.72%

Source: Government Accountability Office report of six
Fed emergency programs. Term-adjusted data.
* Merrill Lynch is now a unit of Bank of America, Wachovia is a unit of
Wells Fargo, Bank of Scotland is a unit of Lloyds Banking Group

The GAO report doesn’t specifically mention Dudley but it did provide his name to the office of Sen. Bernie Sanders of Vermont , according to the lawmaker’s spokesman, Michael Briggs.

Sanders had requested the GAO report.

In the Dudley case, the GAO said the New York Fed’s ethic’s office supported the waiver because selling the shares might have violated federal securities laws since Dudley had access to non-public information.

The GAO, a non-partisan, investigative arm of Congress, said the Dudley case highlighted the need for a comprehensive system to deal with conflicts of interest.

“Given the magnitude of the assistance and the public’s heightened attention to the appearance of conflict related to the Fed’s emergency actions, existing standards for managing employee conflicts may not be sufficient to avoid the appearance of a conflict in all situations,” the GAO said.

Granting waivers in a crisis “may not provide time for formal review of a potential conflict before key decisions must be made,” the report said.

A New York Fed spokesman said Dudley had purchased the shares before he joined the Fed.

“Subsequent to the waiver and following his appointment as President of the New York Fed, Mr. Dudley volunteered to dispose of the shares at pre-determined dates, agreed to by the New York Fed’s ethics office. All shares have been disposed of,” the spokesman said.

In another area of concern, the GAO said the Federal Reserve Board in Washington did not conduct a stress test of losses that could have occurred.

The watchdog agency also said the Fed blocked at least 30 institutions from auctions of discount-window loans, but did not always document these decisions and assure that the 12 Fed district banks applied these restrictions consistently.

Special restrictions put on two of the Fed’s 20 primary dealers were also made “on an ad-hoc” basis, the GAO found.

The Fed also extended credit on favorable terms to the London-based affiliates of a few primary dealers — Goldman Sachs
GS, -0.14%
Morgan Stanley
MS, -0.59%
and Merrill Lynch — without ever documenting the reasons behind the decision.

In another case, the New York Fed allowed an AIG-related firm to continue to have access to the commercial paper funding facility even though a change in program terms by the Fed board in Washington likely would have made it ineligible.

In addition, the GAO also said that the Fed awarded many lucrative contracts on a noncompetitive basis to help carry out the emergency lending. The central bank did not review compliance of these contracts in some instances for as long as 12 months.

The agency said the contracts could have been improved to limit their duration.

The GAO said that Citigroup Inc
C, +0.14%
had $2.5 trillion in transactions under the Fed loan programs it’s reviewed, followed by Morgan Stanley at $2 trillion, Merrill Lynch & Co. at $1.9 trillion and Bank of America Corp.
BAC, +0.20%
at $1.3 trillion.

Barclays PLC
BCS, -0.39%
of Britain was the largest foreign borrower at $868 billion.

Adjusting for the length of the term, as shown in the chart, and Bank of America was the largest borrower at $68 billion.

The Dodd-Frank Act, signed into law one year ago today, required the one-time GAO audit of the Fed’s emergency loan programs and other emergency loan programs during the financial crisis of 2008. Read more on anniversary of Dodd-Frank.

The measure was drafted by Sanders, who agreed to make several changes to it to garner the support of the Obama administration and wavering senators who had concerns with the original measure.

The legislation originally would have left open the possibility of future audits, however, Sanders eventually compromised on the single audit. Long-time Fed opponent Rep. Ron Paul (R., Texas) was also a key driver of legislation to audit the Fed.

More work to end ‘too-big-to-fail’

Separately, Fed Chairman Ben Bernanke told senators that it will be some time before “too big to fail” benefits of the Dodd Frank Act will be achieved.

“I think we absolutely must get there, and there are many aspects to Dodd-Frank which, you know, if carried to their fruition -- and a lot of work remains -- will help us get rid of ’too big to fail.’”

One key measure in the law, passed one year ago, seeks to limit the perception that big banks cannot be allowed to fail and would be bailed out in a future crisis. That Federal Deposit Insurance Corp. is implementing that provision, known as “orderly liquidation authority.” Read about one-year anniversary of Dodd-Frank

It allows the FDIC to dismantle a failing mega-bank by using taxpayer dollars to make payments to its creditors and counterparties so they don’t fail as well, a scenario that would further upset the markets.

Critics of the measure say the perception remains that big banks are ‘too-big-to-fail’ because they could still receive “backdoor” bailouts through the liquidation authority.

Bernanke said that it would be a sign of success if large firms start to try to make themselves smaller to avoid some of the new regulations and oversight required of them by the new law.

“If we see the costs of funding increasing because the backstop of the government is not there — we’re not there yet, but I do note that some of the rating agencies have been talking about downgrading large banks, based on the possible absence of government support in a crisis,” Bernanke said.

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